ACC 818 — Module 12: Monetary Policy in Canada
The course closer. How the Bank of Canada actually conducts monetary policy in practice, the inflation-targeting framework, the role of lags, and contemporary debates.
Learning Outcomes
- Explain how the BoC implements monetary policy by targeting interest rate vs. money supply directly
- Critique endogenous money supply theory
- Diagram expansionary vs. contractionary monetary policy via the transmission mechanism
- Understand long and variable lags
- Review pre-exam
Topic 1: Monetary Policy
Two policy stances
- Expansionary (loose) — lower interest rates, more loanable funds → boost investment and consumer borrowing → fights recessions.
- Contractionary (tight) — higher interest rates, less loanable funds → restrains spending → fights inflation.
Use cases
- Recession + high unemployment + GDP < potential → expansionary policy can return economy toward potential.
- GDP > potential, inflation rising → contractionary policy can ease overheating.
Risks
- Overly loose policy → triggers inflation.
- Overly tight policy → triggers recession.
- This is what makes monetary policy hard: timing and dosage matter as much as direction.
Why the BoC targets the interest rate (not the money supply)
The BoC could in theory pick either. It picks the interest rate because:
- It has imperfect control over the money supply.
- The money demand curve shifts unpredictably.
So the BoC sets a target overnight rate, and the money supply adjusts endogenously to whatever level supports that rate. (During COVID, it also used quantitative easing, which is a deviation from this normal mode.)
Inflation Targeting
The BoC’s framework since the 1990s.
- Set an explicit inflation target (in Canada: 2% within a 1–3% range).
- Monitor the output gap as a short-run guide.
- The “divine coincidence” — focusing on inflation as the long-run target also tends to stabilize output in the short run.
Technical complications:
- Distinguishing core CPI from headline CPI (volatile food/energy).
- Interpreting exchange rate movements — different sources of FX changes call for different policy responses.
Lags
Monetary policy operates with long and variable lags:
- Action today → effect on output in several months.
- Effect on inflation takes even longer.
This forces monetary policy to be forward-looking. The BoC must act on what the economy will look like in 12–24 months, not what it looks like today — which makes communication with markets and the public difficult.
Monetarists vs. Keynesians (Historical)
- Monetarists — money supply is the dominant driver of nominal output; monetary policy is powerful and should follow rules.
- Keynesians — fiscal policy and aggregate demand matter more; monetary policy is one of several stabilization tools.
- Modern central banks blend both views, while emphasizing rules-based inflation targeting.
Topic 3: Contemporary Debates
- Replacing the BoC with cryptocurrency (Pierre Poilievre’s proposal) — rejected by central banks. Crypto is volatile (BTC fell below $20K in 2022), unsuitable as a stable monetary anchor.
- Central Bank Digital Currency (CBDC) — programmable, allows micro-targeted monetary policy and faster transmission. Under research at the BoC; not imminent.
- Independence — empirical research links central bank independence to better inflation outcomes. Political pressure to abolish or constrain the BoC threatens this.
Key Terms
Expansionary Policy · Contractionary Policy · Overnight Rate · Quantitative Easing · Inflation Targeting · Output Gap · Core vs. Headline CPI · Long and Variable Lags · Monetarism · Keynesianism · CBDC · Central Bank Independence